We haven’t heard JPMorgan CEO Jamie Dimon go this dark on China in a long time

Something dark is happening in China’s banking system. It hasn’t been able to penetrate our noisy news cycle here on the other side of the world. But Jamie Dimon, the CEO of JPMorgan, knows about it.

“They’ve kicked out all foreigners twice in their history,” Dimon told a crowd at the Milken Institute’s Global Conference on Monday, addressing concerns with China’s financial system. “They might do it again.

“If you’re a shareholder of JPMorgan Chase, I just want to tell you, we’ll be fine. It’ll hurt. It won’t be a good year. But we’ll make money, OK?”

This from a guy who at the end of March said Chinese banks could “buy us one day.”

The last time Dimon was close to this negative was in early 2016, when China’s markets were roiling on concerns about debt piling up in its banking system. But China’s markets have been quiet so far this year.

Here’s what’s different now: Over the past few weeks, there have been signs that the Chinese government is serious about reducing leverage and debt in its banking system.

China Banking Regulatory Commission chief Guo Shuqing said last month that he must resign if the banking industry was a mess, and Chinese President Xi Jinping has been sitting in Politburo meetings where “financial risk” is the topic of discussion, according to the South China Morning Post.

This means a few things, and most of them have to do with lending. For one, it means the government will try to get banks to be more truthful about what they have on their books, and that means cracking down on the shadow banking system.

That sounds good, but since the government started making noise about regulation, Chinese markets have slumped. That’s because it also means less lending to market participants and to brokerages who then lend to clients who want to lever up and get into the market.

In other words, this is upending the system as everyone knows it.

Things get messy

China’s shadow banking system is mostly made up of wealth management products, which are debt or debt-like instruments that pay out higher interest rates to investors. Banks used to keep WMPs off their balance sheets, but no more. The People’s Bank of China just put off-balance-sheet WMPs on its macroprudential assessment of banks’ risks.

This is a warning to banks that they can’t hide anymore. Plus, the CBRC is demanding that banks keep more liquidity on hand to deal with WMP risk.

The CBRC is also cracking down on money that banks lend external managers, known as “entrusted investments.” One American investor in China who spoke on condition of anonymity told Business Insider that banks were lending to some investment firms and finding there was little recourse to get their money back.

That’s because the banks are lending to brokerage firms with high interest. The brokerages then lend to customers, and they often allow them to extend leverage if they have a problem. The brokerages make their money from trade execution and sharing in returns. They get paid first.

Banks get paid … whenever. All of that has been building on banks’ balance sheets for so long that the government has to act.

The question is how. What scares Dimon – and likely the stock market – is that if this is done too quickly, regulators may also sap liquidity from the system, killing smaller players and grinding things to a halt.

And then, of course, there’s the fact that China represents one-third of the world’s economic growth, and anything that devastates its banking system devastates everyone.

Timing, timing, timing

Economically, China has had an easy go of it in 2017. Up until just about now, the economy has been stable. For example, for the first time since 2012, factories have stopped shedding jobs – a stark reversal from last year. That’s why the government is taking this opportunity to reform the financial system.

But that moment of opportunity could be ending as you read. Manufacturing numbers for April came in below expectations.

“A slide in the Caixin manufacturing purchasing managers’ index, a key gauge of factory activity, adds to the impression that China’s 2017 growth is already past its peak,” Bloomberg economist Tom Orlik wrote in a recent note.

“The index came in at 50.3 in April, down from 51.2 in March and missing expectations of a 51.3 reading. That points to a manufacturing sector continuing to expand, but at a glacial pace. Taken together with a decline in the official PMI and slumping metals prices, it suggests China’s growth may already have returned to a slowing path.”

In other words, it may be a little late to move on the banking system. But all Xi has is now, and the game is already in motion. Dimon will just have to hold on like everyone else.